What to do when everything looks expensive

After the yield story came the growth story. With prices up across the board, what's an investor to do?

Wherever one looks these days, a low digit number is never far away. Every asset class has been affected by the plentiful supply of cheap money. The yield on 10-year Australian Government bonds is just 1.95% while bank term deposits offer around 3%, higher than they were a few months ago but still unappealing. And don’t get me started on the real yield on investment properties, if you can find one at all.

As the prices of supposedly safe asset classes have risen, investors have bounced up the risk curve, attracted by the relatively high yields in blue chips stocks. Take Sydney Airport, for example. The price has more than doubled since we upgraded it as part of our ‘high yield & safe’ mini-portfolio in February 2013. Back then it offered a pre-tax yield of 6.6%. Today’s equivalent figure is 4.5% – not such a high yield and not so safe.

Dropping like Buys

Until about a year ago, anything with a reliable yield, especially stocks juiced up on debt, experienced booming share prices and falling yields. That knocked a bunch of stocks off our Buy List, including Virtus Health, Monash IVF and Hotel Property Investments, as well as the other two stocks from our ‘high yield & safe’ mini-portfolio, BWP Trust, which gained 40% before we downgraded to Sell in August 2015, and ALE Property, which is up 87% (on top of some generous distributions).

Key Points

  • Opportunities can be fleeting

  • Patience rewards

  • Perhaps also look for high-quality Holds

Then the market woke up to itself, realising that maybe, just possibly, investors had overcooked the yield story. Stocks like Telstra and the big banks have since pulled back but the hunt for returns better than term deposits continued apace. Growth stocks were next to get a run. And why not? If you want that additional 3% but aren’t prepared to bear the high prices and dividend payout ratios of yield-orientated stocks, organic growth seems like a good bet.

That removed a further swag of stocks from our Buy List, including Seek, ResMed, Nanosonics, SomnoMed, TradeMe, Carsales.com, Caltex, which almost doubled before we downgraded it to Sell in February 2015, and Hansen Technologies, which has tripled since we first upgraded it in October 2014.

The upshot is that the number of stocks on our Buy List has halved in only a few years. If, like us, you’re driven by a desire to find cheap stocks with a decent margin of safety, that poses a problem, to which we offer three potential solutions.

Fleeting opportunities

The first is to pursue the challenging strategy of doing nothing at all. Just because there are only 12 stocks on our Buy List now does not imply an absence of opportunities. It only takes a few down days for some stocks to earn an upgrade. Our Brexit Buy list, published on the Sunday following the UK’s fateful referendum, upgraded four companies with UK exposure to Buy and listed four more as likely upgrades, with a couple of ‘possibles’ thrown in. Although the UK-related stocks still trade below the buy prices of that time, many of the remaining opportunities quickly disappeared.

That tends to be the way of it: cheap prices come and go quickly. Sydney Airport was on and off our Buy list for six years between 2008 and 2014, earning more than 30 separate Buy recommendations, but our recommendation to Buy Reece Australia in April this year lasted all of 10 days before the price ran away from us and, late last year, Seek lasted less than a month. The number of stocks on the list reflects the number of Buys at a particular time, but says little about how many Buys we might make over a year. Doing nothing might be difficult but knowing that a few upgrades could be just around the corner should make it easier.

That’s especially true given our newly expanded analytical team, now holding more Dragons Dens than ever. As senior analyst James Greenhalgh says: ‘Some are smaller stocks but there are a couple of larger, high-quality companies I'm looking at. The important thing to remember is that an upgrade happens when it happens’. That’s where the patience comes in, and the ability to act opportunistically when we do upgrade a stock, like when Brickworks joined the Buy list yesterday.

If you don’t want to miss out, you need to be a member at the time of each Buy recommendation, because it could be a fleeting opportunity. Then you need to have the courage of your convictions. And while you wait? With inflation running at 1%, a term deposit paying 3% isn’t so bad.

Take an overseas trip

The second option – fishing in a bigger pond - is for those that don’t want to wait, that want to put their capital to good use now. Since we covered four internationally-focused listed investment companies in International LICs take on the world in July 2013, more have joined their ranks, including Geoff Wilson’s Future Generation Global Investment Fund, the Platinum Asia Investments Fund, PM Capital Global Opportunities Fund and soon-to-be listed Antipodes Global Investment Company.

Table 1: Holds near our Buy prices
  Current price Buy price Premium /(disc.)
to Buy price (%)
Close to being Buys      
Top Holds      
BHP 21.39 20.00 7
Carsales 11.83 11.00 8
CBA 73.15 70.00 5
Seek 15.71 14.00 12
Trade Me 5.34 5.25 2
Woolworths 23.00 23.00 0
Others worth considering      
Navitas 5.22 5.00 4
Oil Search 6.51 6.50 0
Platinum Asset Mgmt 5.03 5.00 1
Soul Patts 16.15 15.00 8
Tatts Group 3.86 3.50 10
Virtus Health 7.83 7.00 12
Woodside 26.52 27.00 (2)
Close to being Spec Buys    
Myer 1.17 1.25 (6)
PMP 0.62 0.60 3

There are only two rules to follow when buying LICs. Rule 1: always purchase at a discount to fee-adjusted NTA (see this article for more). Rule 2:  Rule 1 is useless if the assets to which your investment is exposed are overpriced. Only one international LIC meets these criteria right now. If you’re tempted, please tuck into this review.

When Holds can be Buys

The third strategy requires some flexible thinking. Clearly, a Hold recommendation is not a Buy. But there’s a grey area somewhere between the two that becomes a little more visible in times like these. All our Hold recommendations show some value relative to cash or a term deposit. If they didn’t, we’d recommend you Sell rather than Hold.

As research director James Carlisle says: ‘The point at which you buy to a large extent comes down to how greedy you want to be. When great opportunities are plentiful, you probably want to be very greedy, demanding a cheap price and a big margin of safety. But when opportunities are few and far between, as they are now, a fair price for a high-quality business is more easily justified.’

That’s a sound basis for trawling through our Hold recommendations and picking out a few high-quality stocks near our Buy price. Here’s the list, with the stocks listed at the top being James’s preferred picks, not so much because of their proximity to our Buy price, but more on the basis that ‘if you’re going to allow your margin of safety to shrink, it probably makes sense to stick to higher quality stocks, which should produce fewer nasty surprises’.

As ever, it’s also generally a good idea to buy in stages, so that if better opportunities come along you will be able to take advantage.

Finally, note that a couple of the stocks are already below our Buy prices. We generally wait for a bit of clear space before upgrading (to avoid flitting around too much as much as anything else), but some new additions to our Buy list could be just around the corner.

Note: The Intelligent Investor Growth and Equity Income portfolios own shares in many of the stocks mentioned – but sadly not Reece, because we were being too greedy. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

Disclosure: The author owns shares in many of the stocks mentioned.

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